Technical Analysis (Part 1): History, Theory and Philosophy

Welcome to the new Technical Analysis Series from Stephen Hoad. Stephen is the Technical Strategist at Stockopedia.com and he’ll be publishing a library of technical analysis resources over the next few months.   We're hoping to launch some courses together in due course, so let us know how you find the content in the comments below.

This series will comprise 25 introductory articles covering all aspects of technical analysis, from the very basics through to some more advanced theory. Hopefully, these articles will whet your appetite for the subject and inspire you to take up technical analysis (if you haven't already) and use it in your trading and investing. My aim is to enhance your existing knowledge and give you an insight into how technical analysis can be used as an effective trading tool, both to make and save you money and give you new roads to follow. This is a vast, often misunderstood subject, so the aim of this blog series is to make it more accessible by breaking down a few of those boundaries.

In this first article, we explore the roots of technical analysis. It is vitally important for you to understand where technical analysis has come from and the thinking behind it, if you're ever going to successfully use it in practice.

What is technical analysis?

Technical analysis is a very straightforward concept: It is the analysis of market activity (price, volume and open interest), predominantly through the use of charts, with the goal of forecasting future price trends. Many of the tools used in technical analysis can also be found in use in areas such as quantitative analysis and behavioural science. It is a very flexible, adaptable, multi-time dimension frame approach to trading and investing.

Technical analysis is built on three pillars:

1. Market action discounts everything i.e. the price is the price -  you don't need to necessarily know how it got there, other than supply and demand made it so.

2. Prices move in trends

The S&P 500 is a great recent example of a price trend - why would you go short in the longer term if you saw a chart like this?

3. History repeats itself

Historically, US gasoline is repeatedly bullish at the start of the year:

Technical analysis is very different to fundamental analysis. Fundamental analysis is all about value; is something fair value, under value or over value? Decisions to trade or invest are based around a lot more physical research - earnings, dividends, assets, new products, interest rates, a country's economic make up, how much copper is coming out of a mine or oil being pumped out of the ground etc etc. The downside to fundamental analysis is that it can take a lot of time to put together and is difficult to execute, especially around trade and risk management concepts. It does work though and cannot be argued to be any worse or better than technical analysis.

Mathematicians often disagree with the approach and methods of both technical and fundamental analysis due to the efficient market hypothesis / random walk theory. They often say these approaches are self-fulfilling. But both do work - some of the richest, most successful traders ever have adopted these approaches. The end game is to make money and if you find an approach that works then you should stick to it. Often it comes down to your own personal psychological make up as to which approach you'll adopt.

The origins of Technical Analysis

Technical analysis has been used 'unofficially' really since the beginning of civilised time in all parts of the globe - spotting price trends, noticing repeatable patterns in behaviour, whether that be on a market stall in ancient Rome or the demand for Tulip bulbs hundreds of years ago in Holland. Generally and historically, technical analysts view the development of the subject from two separate geographical regions: The West and Japan. In a globalised world today, it feels strange that there could be such distinctions, but as you get to know technical analysis you will clearly see the cultural difference between the two. Historically, Japan was very much a 'closed shop' until the latter part of the 20th century and it is only now that we are learning in the mainstream, some of their wonderful approaches to technical analysis.

The Japanese Approach

Recognition goes to Homma Munehisa for the development of Japanese technical analysis. In the 18th Century he introduced the concept of candlestick charting; a 'story telling' method that, for example, could give traders in Rice a more transparent picture of the trends and behaviour of price in this commodity.

Other concepts such as Renko and Kagi charting are more recent. They can look alien to the Western user due to the way the Japanese culturally view time. Ichimoku, another charting concept, was born in the 20th century by a journalist putting together a multiple trading system approach. Again, until recently, it would have been unfathomable to any Western user. The main differences to the Western approach? The Japanese charts are much more pictorial and they deal with time in a very different manner to what we are used to in the West.

Renko charts - a very different approach to studying price - takes away time. Once you know what they're telling you they make a lot of sense!

Western technical analysis theory and philosophy

While Japan was doing its stuff, over in the Netherlands, Joseph de la Vega was writing about technical analysis and the markets as far back as the 17th century. Most market places in Europe had some form of domestic price tracking method, so the participants could understand where price had been and where it could go to. More formally, methods such as point and figure arose in the USA toward the end of the late 19th and early 20th centuries. The 'Godfather' of the western approach to technical analysis is said to be Charles Dow. Through his methods of measuring the strength of the US economy through indexing, he inspired a generation of individuals such as Elliott, Gann & Wyckoff, to develop technical analysis theory in the early part of the 20th century. Dow introduced the theory of trends moving in different phases, volume, confirmation, reversals, signals and much more besides.

Point and Figure charting one of the oldest Western methods used for price analysis:

Global Trading Environment

Today, in a globalised world and with the huge advancements in technology, technical analysis has developed at a massive rate. Technology has meant that almost anything is possible, and new theories and ideas and approaches are springing up daily. Technical analysis is very popular with the HFT's (High frequency Traders), algorithmic and systematic traders due to its computer based functionality and the repeatable patterns and movement in prices that can be found using technical analysis.

Why use technical analysis?

Quite simply, technical analysis is a fantastic tool for making and saving you money. It will save you bundles of time (over the fundamental analyst). You will find it removes huge chunks of the 'psychological' game of trading and investing from the equation. It creates discipline and is essential for the risk and trade management of your portfolio - whether that be knowing when to take profits, setting stops or getting out of bad trades. It seriously aids the timing of your trading and investing i.e. choosing the optimal point to get in and out of a trade. It is great for creating a systematic approach to your trading. It is also a great tool to add alongside other trading approaches such as fundamental and behavioural analysis. Technical analysis may, to the uninitiated, look to be a jumbled, confused mess of wiggly lines and flashing colours but it is actually very simple to understand and apply.

Hopefully this brief introduction to the world of technical analysis has sparked your interest and left you wanting to learn more?!

Next Time: Technical Analysis (Part 2): “Rules you need to know”

To start exploring some of the charting and technical analysis ideas in Stephen's series, you can get started with Stockopedia Charts.